Volcker Calls for New Look at Fair-Value Rules

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Calling for a fresh look at current mark-to-market financial reporting rules, Paul Volcker, a top economic adviser to President-elect Obama, has signed off on a financial-reform program more sympathetic to bankers’ views than the current Financial Accounting Standards Board’s fair-value regime has been thought to be.

Indeed, the report on stabilizing the financial system that the Group of 30, which Volcker chairs, issued yesterday, seems likely to reopen what has been a furious debate between banks and investors on the value of market-to-market accounting in a time of extreme illiquidity. And it does so just as the debate seemed to be have been resolved in favor of investors.

Over the past year, bankers and investor groups have hotly contested the validity of the new fair-value accounting regime ushered in by Financial Accounting Standard No. 157, which spelled out how companies should measure the fair value of illiquid assets and liabilities as well as liquid ones.

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Spearheaded by the American Bankers Association, representatives of financial institutions contended that overly rigid application of the standard forced them to value their assets at fire-sale prices, thereby shrinking their balance sheets and hastening the onset of the credit crisis. For their part, the investor groups argued that the rules provided much-needed up-to-the- minute transparency to financial reporting.

By year’s end, it appeared that the investor groups had won the battle. In a report to Congress issued recently, the Securities and Exchange Commission affirmed that the Financial Accounting Standards Board’s fair-value rules should stand.

Speaking at a press conference in New York on Thursday that introduced a report on financial reform issued by the Group of 30, an international body of prominent finance officials and economists, Volcker questioned, however, “whether a naive, across-the-board application of mark-to-market accounting [is] suitable for regulated institutions.”

Responding to a question from CFO.com at the press conference, Volcker, a former chairman of the Federal Reserve Board as well as the International Accounting Standards Board, suggested that because commercial banks engage in a number of balancing acts, the gauging of the fair value of their assets and liabilities should be subject to a more flexible and principles-based system than exists today.

Such regulated banks “are intermediating discrepancies in maturities. They are intermediating between the borrower and the lender. The borrower wants the money and the lender wants it safe,” Volcker said. Acting as the middle-man in that way entails operating risks that must be accounted for and reserved for, he says, adding, however that the group hasn’t “got a magic answer.”

In its report, “Financial Reform: A Framework for Financial Stability,” the group, which includes such economics luminaries as Paul Krugman and Martin Feldstein and such prominent government officials as Ernesto Zedillo, the former president of Mexico, and Timothy Geithner, President-elect Obama’s choice for U.S. Treasury Secretary, went further in its criticism of the current system of fair-value accounting.

The group sites an “underlying tension” between the “business purposes” of banks—especially the funding of illiquid loans with short-term deposits— and investors’ need for “the best possible current information on the immediate market value of assets and liabilities.” The report makes a clear distinction between such “regulated” commercial banks and what has been called elsewhere the “shadow” banking system: investment banks, hedge funds, private-equity firms, and other non-regulated lenders.

Until recently, when the Financial Accounting Standards Board, IASB, and the Securities and Exchange Commission issued guidance that the report’s authors consider helpful, accounting regulators and standards setters have sought to quell the tension by “forcing as much of the accounting and valuation of all assets and liabilities as possible into an accounting model designed and developed to address market values of liquid tradable instruments.”

Without mentioning it by name, the authors were surely referring to FASB’s controversial statement on the measurement of fair value, FAS 157. The lumping of illiquid and liquid assets and liabilities into a single valuation system has resulted in a “forced fit” of currently untraceable instruments into methods applicable only to easily traded ones, according to the authors.

The mismatch has yielded some wildly illogical standards. The report’s authors cite, for instance, a provision in 157 under which a company can boost its reported earnings by becoming less creditworthy. Thus, in paragraph 15, FASB states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back. Thus, as the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease—and may even provide an earnings boost.

Shoehorning illiquid assets into valuation models made for liquid ones has also yielded valuations that “sometimes have limited relationship to expected discounted cash flows,” according to the authors.

Summing up the group’s position, the authors say that, for banks whose main purpose is to balance credit and liquidity risks, fair-value accounting “needs to be better aligned with the firm’s business model.” On the other hand, a “pure mark-to-market model is generally preferred for trading activities and most elements of market risk,” they add.

More concretely, the group makes these recommendations:

• “Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.”

•Principles-based standards that apply more closely to the business models of regulated banks should be developed. The standards, which should encourage more transparency than current accounting rules do, should be reviewed by and coordinated with bank regulators.

•Accounting principles should be made “more flexible” to enable regulated banks to hold on to credit reserves sufficient to cover expected losses “across their portfolios over the life of assets in those portfolios.”